1. Technical Field
This invention relates to a system and method for investment of funds, and more particularly to an investment vehicle that utilizes covered-call options in a tax-advantaged manner to reduce downside investment risk while also reducing adverse tax consequences relative to other conventional investment vehicles.
2. Background Information
Throughout this application, various publications, patents and published patent applications are referred to by an identifying citation. The disclosures of the publications, patents and published patent applications referenced in this application are hereby incorporated by reference into the present disclosure.
Hedging may be defined as the purchase or sale of a security, derivative (such as options or futures and the like) or other instrument in order to reduce or neutralize all or some portion of the risk of holding another security or other underlying asset. Hedging equities is an investment approach that can alter the payoff profile of an equity investment through the purchase and/or sale of options or other derivatives. Hedged equities are usually structured in ways that mitigate the downside risk of an equity position, albeit at the cost of some of the upside potential.
A buy-write hedging strategy generally is considered to be an investment strategy in which an investor buys a stock or a basket of stocks, and simultaneously sells or “writes” call options that correspond to the stock or basket of stocks. An option can be defined as a contract between two parties in which one party has the right but not the obligation to do something, usually to buy or sell some underlying asset at a given price, called the exercise price, on or before some given date. Options have been traded on the Chicago Board Options Exchange since 1973. Call options are contracts giving the option holder the right to buy something, while put options, conversely, entitle the holder to sell something. A covered call option is a call option that is written against a securities position (such as, for example, a stock or a basket of stocks and the like) or other asset (such as, for example, financial futures, commodities and the like) held by the option seller.
Buy-write strategies provide option premium income that can help cushion downside moves in an equity (asset) portfolio; thus, some buy-write strategies significantly outperform stocks when stock prices fall. Buy-write strategies have an added attraction to some investors in that buy-writes tend to help lessen the overall volatility in many portfolios.
Indexes have been devised to track the return of certain buy-write strategies. Such indexes are discussed in U.S. Patent Application Publication No. 2003/0225658 to Whaley. One such exemplary buy-write index is the Chicago Board Options Exchange S&P 500® BuyWrite Index(sm) (the BXM Index) which is a benchmark index designed to track the performance of a hypothetical buy-write strategy consisting of owning the stocks in the S&P 500® and writing a series of one-month call options on the full value of the index.
Taxation is a significant concern to investors and others who are evaluating capital investment transactions such as buying or selling a stock. A transaction that yields a certain before-tax profit may prove less profitable after taxes are assessed. Similarly, a transaction that produces a financial loss may actually prove to be less of a loss when realized tax losses are used to offset taxes on capital gains realized on other investments.
Frequently an investment is sold to re-invest the proceeds in another potentially more profitable capital investment vehicle, and so not merely to liquidate profits. However, the consequences of selling a currently held investment instrument to buy an alternate instrument can only be accurately evaluated by knowing the tax consequences of the transaction. This is particularly true under most capital gain taxation regimes because different, usually lower, tax rates are applied when the investment is held for longer periods. Under some capital gains tax laws the tax rate may be reduced after a specified holding period, such as 1 year.
One known method that attempts to solve the capital gains tax problem is a low turn-over strategy, where investments are on average held for sufficient periods to qualify for long-term capital gains treatment.
Such a long term holding strategy tends to militate against use of a buy-write strategy, since the premium received from writing covered-call options on individual assets generally gives rise to capital gain or loss taxed at higher, short-term rates. In addition, conventional straddle rules may further penalize such hedging techniques from a tax standpoint. Accordingly, a need exists for a system or method for providing a financial instrument which utilizes a buy-write strategy while also minimizing the adverse tax consequences of such an approach.